Appeals Case Study - Tax Protest Letter to IRS

Background Information

You are retained by the law firm of D, E & F, PC (hereinafter referred to as the PC) to represent it and its shareholders in connection with a civil examination being conducted by the Internal Revenue Service.

The PC is a professional corporation engaged in the general practice of law.  D, E and F are equal shareholders in the PC and are also its principal officers and directors.  The PC files a calendar year 1120 and employs the cash receipts and disbursements method of accounting.

In August, 2008 D, as the attorney of record, was engaged to represent the Estate of John Smith in a wrongful death action against Interdistrict Telephone Company.

In August, 2010, the parties to the Smith case entered into a settlement agreement.  In pertinent part, the agreement provided for a lump sum payment to the Estate and for an attorney's fee in the amount of $ 3,000,000 to be paid to Attorney D.  D received payment of the attorney's fee in September, 2010.  D retained $ 1,000,000 and disbursed $ 1,000,000 to E and $ 1,000,000 to F. D reported receipt of the $ 3,000,000 on Schedule C of his 2010 Form 1040, and claimed a deduction in the amount of $ 2,000,000, which represented the aggregate amount disbursed to E and F.  D issued Forms 1099-MISC to E and F.  E and F, in turn, each reported receipt of the

$ 1,000,000 from D on their respective Schedules C for 2010.

D, E and F inform you that the IRS agent has just concluded his examination of the PC's 2010 return and the 2010 individual returns of D, E and F.  The agent proposes to include the entire amount of attorney's fee from the Smith case in the gross income of the PC.  The agent further proposes to characterize the $ 3,000,000 received by D, E and F as a distribution of the earnings and profits of the PC, taxable as dividend income in the amount of $ 1,000,000 each.

The basis for the agent's determination is set forth in his report as follows:

"Income must be taxed to its earner." Commissioner v. Culbertson, 337 U.S. 733 (1949)

"Attempts to subvert this principle by deflecting income away from the true earner to another entity by means of contractual agreements, however cleverly drafted, are not recognized as dispositive for federal income tax purposes despite their validity under applicable state law. "Lucas v. Earl, 281 U.S. 111 (1930); U.S. v. Basye, 410 U.S. 441 (1973)"

"D, the attorney of record, did not represent himself.  He was an agent and representative of the PC.  The equal splitting of the fee is indicative of the PC's controlling position.  D, E and F are employees of the PC.  Therefore, the attorney's fee is corporate income." "Corporate earnings were received directly by the shareholders.  The fee is includible in corporate income.  The shareholders, therefore, received a dividend."

"Authority relied upon by the agent: Johnson v. Commissioner, 78 T.C. 882 (1982); IRC §301(c); Treas. Regs. §1.301-1."

The agent rejects any argument that if the attorney's fee is corporate income, it is deductible as compensation paid for services rendered by D, E and F.  The agent contends that the compensation paid by the PC to D, E and F, as reflected on its respective tax returns, is reasonable in amount.  Therefore, he concludes, amounts in excess of those already claimed would be excessive and non-deductible.  The agent relies on I.R.C. §162(a) and Treas. Regs. § 1.162-7 for this position.

D, E and F want your opinion as to the merits of the government's case and, whether they should agree or disagree with the agent.  If they are to disagree, they want you to advise them as to what their options are, and which option you recommend.  They understand that you need some time to evaluate this matter.  They ask you to get back to them as soon as possible.

You will find complete texts of Johnson v. Commissioner, 78 T.C. 882 (1982); Home Juice Company, Inc. v. Commissioner, T.C. Memo. 1977-386; and, Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987).  You will also find Opinion excerpts from Loftin & Woodard, Inc. v. U.S., 577 F.2d 1206 (5th Cir. 1978).

Prepare a FORMAL Tax Protest letter to the IRS to prove the compensation was reasonable and provide the necessary support.